Ramesh S Arunachalam
Rural Finance Practitioner
A. Background on NBFC MFI Model
Recently, Dr Rangarajan, one of the most respected figures in the Indian financial sector, remarked that the business model of the (NBFC) MFIs is faulty and this surprised me. And coming on the backdrop of Dr Y V Reddy’s statement that Micro-Finance could indeed be India’s sub-prime, it got me really worried…both about the MFI business model currently operational as well as regulation and supervision of the same…Hence this post…
The dominant MFI model is the commercial model where the MFI is registered as an NBFC with RBI and taps commercial funding (Debt and Equity) through different means. The model is based on fast tracked growth and generally carries a standard loan product - delivered to clients through joint liability groups and/or agents - based on weekly repayments and having loan related insurance. The emphasis is on - efficiency, standardised processes, large outreach and enhanced profitability – all elements of hardcore commercialisation.
While there could be some adaptations to the above model to suit different contexts, by and large, the above description is true of most NBFC MFIs, barring BASIX (which also engages in livelihood finance and tries to deliver other financial services and that makes them a little different). The dominant NBFC MFI model is also based on the notion that, to reach and include vast number of unreached and excluded people (including the poor), MFIs must tap commercial funding in a big way from lenders and investors – Mr Vijay Mahajan’s statement to this effect, when SKS was to tap the capital markets, resounds in memory. And to do this successfully, the model also believes that commensurate (market) returns must be provided to the commercial investors. It is important to note that much of the basic tenants of this (commercial) model have evolved from the global development of new wave micro-finance – which was spearheaded by several stakeholders including CGAP, especially since 1997 onwards[i].
While I look at issues pertaining to the NBFC MFI (commercial) model in a separate post, here, I focus on the regulatory framework as it pertains to these NBFC MFIs here.
I first attempt to share some opinions with regard to regulation of these NBFC MFIs and then, I set out to describe some basic facts about this crisis before raising issues and questions relevant to the regulatory framework that governs these NBFC MFIs…
Further, I would also like to clarify that my objective in doing this exercise is to bring to the attention of the respected RBI Sub-Committee and Respected Board Members of The RBI, various aspects related to regulation and supervision of NBFC MFIs and priority sector lending in India – so that they can bring about appropriate changes to overcome prevalent weaknesses, if any, in the existing framework. The intent here is certainly not to find fault with any individual or department or regulator/supervisor – given their enormous tasks and operational constraints, the work of The RBI and its departments are sincerely well appreciated but at the same time, it is important to constantly strengthen the regulatory and supervisory framework…especially, with inputs from the field…That is the primary objective here…
B. Opinions on Regulation/Supervision of NBFC MFIs
That said, let us move on to some industry specific issues…The issue of micro-finance regulation has always been hotly debated…and very divergent views are available…while people like Dr Nachiket Mor and Ms Bindu Ananth believe that NBFC MFIs are well regulated, others like Mr Daniel Rozas think differently…Read on…
Dr Nachiket Mor and Ms Bindu Ananth write, “In fact all Non Bank Finance Companies (NBFCs) are regulated by the Reserve Bank of India, and the systemically important ones with an asset size over Rs. 100 crore are subject to stringent financial standards, monthly reporting requirements as well as a Fair Practices Code (See: RBI Circular No. DNBS (PD) CC No.185 / 03.10.042 / 2010-11 dated July 1, 2010) that specifically prohibits NBFCs from resorting to “undue harassment” for recovery of loans.”[ii]
Writes Mr Daniel Roizas, “RBI, which holds a pretty tight leash on the banks, has seemed to favor the clearly unworkable self-regulation approach of the NBFC MFIs, in effect allowing them to operate with zero oversight over client protection, portfolio risk, and other critical factors.”[iii] In fact, Daniel has consistently said this and please see another quote from comments on this blog…”Voluntary codes of conduct will not work. Regulators are evading their responsibilities by relying on the industry to police itself.”
When I see such polar extremes in terms of views, I get thoroughly confused… and I am sure you are perhaps feeling the same way…let us delve into this deeper and try and understand the basic context…before looking at the issues…
C. The Regulatory/Supervisory Domain for NBFC MFIs
It is undoubtedly true that a majority of the Indian MFIs (at least in terms of the proportion of clients and gross loan portfolio) are NBFCs and they are also supposedly regulated by the Reserve Bank of India. Technically, they come under the purview of the department of non-bank supervision (DNBS), which, among other things has the following functions:
D. Some Facts on The Indian and AP Micro-Finance Crisis
Having set the context above, let me try and present some basic facts[v] about the present micro-finance crisis in India, from the perspective of regulation and supervision:
The fastest growing MFIs, who have perhaps contributed to the present crisis situation, are mainly NBFCs MFIs, that come under the purview of the Department of Non-Bank Supervision (DNBS), RBI. As the attached data show, these MFIs themselves grew at a phenomenal rate, adding several million clients and several million dollars as Gross Loan Portfolio over the period, April 2007 – March 2009. The data in annexes 1 and 2 suggest the following basic facts:
· 13 of the top 14 MFIs (ranked on the basis of active clients and gross loan portfolio added from April 2007 to March 2009) are NBFCs
· 6 of them are AP headquartered NBFC MFIs and they constitute the largest chunk within this group of 13 NBFC MFIs – 9.76 million clients were added by the 6 AP headquartered NBFC MFIs from April 2007 to March 2009 where as the 8 other state NBFCs MFIs added just 4.52 million clients (this is less than 50% of the outreach of AP headquartered NBFC MFIs). Likewise, these 6 AP Headquartered NBFC MFIs increased their gross loan portfolio by 2.076 billion US $ during this period whereas the 8 other state NBFC MFIs did so by just 703 million US $ (which is less than 1/3rd of the GLP of AP headquartered NBFCs)
· All of the 13 NBFC MFIs (including the 6 AP headquartered NBFC MFIs) file quarterly papers with the department of non-bank supervision (RBI)
· And as the graphs below indicate there was phenomenal growth in gross loan portfolio (GLP) and active clients for 10 of these top 14 NBFCs during the year April 2007 – March 2009
Please note that the phenomenal growth is led by 5 AP headquartered MFIs, who added, between April 2007 and March 2009, 2049 million US $ and 9.59 million clients – which is very significant indeed…Read on…
This is equivalent to each of these 5 AP Headquartered NBFC MFIs adding a gross loan portfolio of Rs 78.55 Crores (Rs 1 crore = Rs 10 Million and exchange rate assumed is Rs 46 per dollar) per month, month after month, quarter after quarter, year on year for the 24 months in question. Please also recall that the department of non-bank supervision is supposed to supervise every NBFC that has a loan portfolio of over 100 crores closely and each of these 5 MFIs were adding almost 78% of that threshold value of (Rs 100 Crores portfolio) every month, month on month, quarter on quarter, year on year for the 2 years in question – April 2007 to March 2009.
In numerical terms, this is equivalent to each of these 5 AP Headquartered NBFC MFIs adding almost 79916 clients every month, month on month, quarter on quarter, year on year for the 2 years in question – April 2007 to March 2009. This translates to adding about 2664 (fresh) active clients every day, month after month, quarter on quarter, year on year for the 2 years in question. This is a huge task indeed…in the past, it has taken many MFIs, several years to reach the figure of 75,000 clients…and/or portfolio size of Rs 75 crores…which is why the RBI specified that NBFCs with asset size greater than Rs 100 crores are sytemically important…and need to be closely supervised…
Clearly, these are trends that should have grabbed the attention of anyone, let alone the regulators/supervisors…
E. Emerging Issues: NBFC Supervision:
E. Emerging Issues: NBFC Supervision:
This being the case, the first issue here is whether or not, this huge and unnatural growth - quarter on quarter, during the period April 2007 – March 2009 - raised any alarms within the department of non-bank supervision, especially with regard to the following:
· What is the motivation of these MFIs to grow at this pace never seen before?
· How are they growing[vi] in terms of market development strategies (client acquisition etc)?
· What is their business model and is it in consonance with the RBI NBFC regulations and the RBI code of conduct?
· Where and how are they getting the resources (Debt, Equity etc) for this burgeoning growth? Where exactly are these resources coming in from (India, Abroad etc)?
· What is the current and likely future impact of this burgeoning growth on the low-income clients?
· Are the RBI NBFC and other codes of conduct being followed in letter and spirit? Do the NBFCs have sufficient governance and systems to manage this turbo charged growth and more importantly not to violate any of the provisions in the law and code of conduct?
· Is appropriate and required KYC documentation available?
At this juncture, it seems pertinent to look at what Dr Rangarajan and other have said about the business model of the NBFC MFIs and also analyse the same…
"The business model of microfinance institutions is faulty. They must revisit the model to support the income earning ability of the borrower," Prime Minister's Economic Advisory Council chairman C Rangarajan said at an event organised here by Skoch Consultancy. Rangarajan said multiple lending done by MFIs is inconsistent with the very repayment capacity of borrower. He said MFIs have been indulging in multiple lending and large parts of the loans are given for consumption purposes and this model of business has landed them in trouble. "Income earning capacity must be criteria for granting loans... The provision of credit for consumption must be a small part of the total loan," Rangarajan said. “[vii]
Others have tended argue for the same and I reproduce a quote from Dr Al Fernandez’s recent post on the CGAP blog. As Mr Fernandez argues,
“The State of the Sector report 2010 (N. Srinivasan) indicates that out of 60 MFIs which reported on profitability, six had ROAs over 7%; thirty five had ROAs over 2%. In contrast the public sector banks in 2009 had average ROAs of 0.6% with the best being 1.6%, while the best private bank had ROAs of 2%. The yield on portfolio confirms this picture; in the case of 23 MFIs it was above 30 %(the highest being 41.29%). The report also says that economies of scale have not led to lower interest rates or lower yields. This implies that MFIs maximized their profits and competition did not decrease rates as it was expected to. The largest MFI recorded a 116% jump in net profit at Rupees 81 crores ($18 million) in the second quarter ending September 2010 as against the corresponding period last year.“
The cornerstone of this argument is essentially this: MFIs engaged in multiple lending for consumption purposes and often, granted loans without assessing the loan absorption of the clients. Implied in this statement is the fact that MFIs have pushed loans indiscriminately to low income clients for consumption purposes without any sensitivity to their debt servicing ability and tried to grow (very fast) in this manner and make super natural profits. Again, as with the above, it seems more and more clear that MFIs grew to attract capital at high valuations (see next point below) and thereafter had to justify these high valuations by providing better returns to investors. And investors likewise, as they had paid huge premiums, wanted to recover their investment fast and hence, were perhaps pushing the MFIs to grow faster…hence, a mutually reinforcing cycle of perhaps multiple/over/ghost lending, fast growth, high profits, very high valuation equity investments, faster growth, greater profits, more returns, turbo charged growth…and so on
Second, it is during this period (April 2007 – March 2009) that the NBFC MFIs (including the above 13 NBFC MFIs among the top 14 MFIs) received equity worth several million US $ and this again should have been disclosed as per the filings. The data suggest the following two basic facts:
· This group of NBFC MFIs can be categorised into 2 groups, on the basis of the equity investment they received and please see graph below
· As a group, 5 of the 6 equity leader NBFC MFIs who received a large inflow of equity were among the top 6 AP Headquartered NBFC MFIs and they are also part of the 13 NBFC MFIs in the top 14 NBFC MFIs. In fact, as noted above, these 5 AP headquartered NBFC MFIs (SKS, Spandana, Share, Basix and Asmitha) grew at a phenomenal rate adding the equivalent of Rs 78.55 Crores per month in gross loan portfolio and about 79916 clients per month…making them systemically very important…
Again, given the above, it would be useful to know whether or not, this unprecedented and sudden inflow of equity, into select NBFC MFIs, raised any alarm bells for the concerned regulators and supervisors, especially in terms of the following questions:
· Why has there been a sudden inflow of equity into micro-finance and at a scale not seen before at all?
· As Ms Naina Lal Kidwai argued at the Sa-Dhan March 2010 National Micro-Finance Conference and as Mr N Srinivasan wrote in the State of the Sector Report (2010), we surely need to understand what made micro-finance so attractive to equity investors, especially, during a period serious global economic crisis?
· What kind of MFIs are receiving this equity inflow, at what valuations and why?
· Who is investing in these MFIs and what are their expectations in terms of returns etc? What returns, if any, did the investors actually get?
· Where is this equity money coming in from in terms of countries?
· Is there anything abnormal with the operations of these MFIs in terms of growth or profits or earnings per share or promoter/management compensation etc?
There is also some very interesting data with regard to these 5 AP Headquartered MFIs in the recent Intellecap Inverting the Pyramid report:
Intellecap’s analysis and other data provide a good understanding of the above aspects.
As the Intellecap report notes, “Indian MFIs are receiving the highest valuations in the world. A recent report by the Consultative Group to Assist the Poor (CGAP) and JP Morgan[viii] shows that the median price to book value (P/BV) multiple in India is 5.9, thrice that of global multiples. Some have been quick to call this “irrational exuberance” on the part of investors. Analysis shows that while the leading large MFIs have been able to command very high premiums, valuations vary across the sector based on investor type, MFI class and stage of investment.
The vast market potential, demonstrated growth of the sector and positive macro-economic outlook contribute to relatively higher valuations in India. In addition, the number of investors (see below) chasing deals with the few large, high growth MFIs has driven up their valuations considerably. These MFIs are able to command valuations upwards of 10 times their projected Profit After Tax (PAT). Early stage MFIs on the other hand, are typically valued lower, at between one and three time book value[ix].
Across the sector, the drivers of value are primarily growth and returns, both demonstrated and potential. Thus, to put Indian MFI valuations in perspective, it is instructive to compare the return on equity (Roe) and PAT growth of the leading MFIs with other financial service business, banks and NBFCs. As shown in Table 1, leading MFIs outperformed Banks and NBFCs on both counts. On average, MFI Roe is 32.1%, a full 12 percentage points higher than that of Banks and NBFCs. MFI profits grew over three times that of the sample banks’, and five times that of the sample NBFCs’ between 2006 and 2009. The closest comparable in this sample to MFIs in terms of business model is Mannapuram General Finance[x], as their clientele is similar to that of MFIs and loan sizes are relatively low (INR 20,000), although their loans are backed with collateral. Despite the company’s Roe and PAT growth being lower than those of MFIs, its P/BV is at 8.4, higher than average for leading MFIs.
Thus, given the enormous market potential, the ambition of leading Indian MFIs, and their demonstrated high growth, prudent cost management and thus high returns, the current valuation levels are not surprising.”[xi]
The above makes it reasonably clear that one of the major reasons for MFIs to grow, in the manner they did so, was to attract capital at higher valuations…
A third issue is also relevant here. The amount of (priority sector) debt leveraged by these 13 NBFC MFIs (in top 14 MFIs) and other NBFC MFIs is obviously huge and that would be clear from the filings made by them to the department of non-bank supervision. In numerical terms, the growth of debt for MFIs from commercial banks and SIDBI is given below and this growth is best described as phenomenal:
As Mr N Srinivasan says in the 2010 State of Sector Report,
“Bank loans to MFIs did not exhibit any overt signs of increased risk perceptions towards the microfinance sector. The total loans extended to MFIs and outstanding at the end of March 2010 is estimated at Rs.15085 crore.[xii] Public sector banks have taken to MFI financing in a big way. Public sector banks (not including SIDBI) had an exposure of Rs. 4737 crore to MFIs in comparison to private sector banks' exposure of Rs. 4133 crore. Foreign banks had outstanding loans of Rs.1994 crore and FWWB had increased its exposure from Rs. 295 crore last year to Rs. 360 crore. SIDBI almost doubled its exposure to Rs. 3808 crores during the year. At this level SIDB! had a share of more than 25 per cent of the market.”
Again, the key question here is whether or not, the department of non bank supervision (DNBS) felt alarmed about this burgeoning growth of PSL funds to NBFCs in terms of the following:
· Is there any cause for alarm given the huge growth of (PSL and other) funds from banks and DFIs to MFIs?
· How and where are the MFIs investing these priority sector loan (PSL) and other funds?
· For what specific loan purposes are these PSL and other funds being used?
· Which banks/institutions are providing these PSL funds to different MFIs? What do the growth trends say?
· Is there any reason to believe that these priority sector loan funds may be used for non-priority sector purposes? If so, what are the reasons and what can be done about this?
· Have any of the institutions provided loans from their PSL funds to their promoter, senior management and/or board members? If so, for what purposes?
All of the above questions need to be looked into by the RBI sub-committee and RBI because even some interest from the concerned department and/or any of their local offices, cautioning the MFIs, might have, after all, prevented this crisis…and saved us in some measure. This becomes even more significant when one considers the fact that during the period in question (April 2007 to March 2009), the top 6 AP MFIs grew at a phenomenal rate, were able to receive significant equity infusion and perhaps used this equity to leverage PSL funds in larger measure…and all of this came in the backdrop of the Krishna district crisis that the RBI successfully intervened and sorted out…
Therefore, it is imperative that the RBI sub-committee and RBI look into all regulatory and supervisory aspects given above for as much as the micro-finance industry is a sunrise sector as claimed by several industry experts, it is also a very sensitive area that requires careful handling…from a client perspective… And this is especially true given the fact that MFIs are trying to sell what is perhaps the most attractive product on the face of this planet to a very vulnerable set of people…
It would also be interesting for both of them to look at whether the department of non-bank supervision and the department of banking operations development that deals with priority sector lending were in fact talking to each other on something unusual happening in the micro-finance industry…
That said, the role of priority sector funds also needs further analysis…Several issues should be of interest to RBI and the Malegam committee…and these are highlighted below...read on…
F. Emerging Issues - Priority Sector Lending:
As before, let us look at some specific data…
The tables and figure below provides a ranking of lending to MFIs by top commercial banks and SIDBI…
Several questions arise from the above data, for the department of banking operations development (DBOD):
a) How does the department of banking operations and development (DBOD) of The RBI satisfy that a loan made through a bank and via an NBFC MFI is legitimately priority sector?
For example, just because a loan has been claimed to be given to weaker sections, it cannot be taken as priority sector. There must be some supervisory mechanism to ensure that it really is priority sector.
Otherwise, a loan supposedly given to non-existent clients or loans given to promoters to buy shares in the same MFI or loans given to well off people or loans given through agents (where end use is not traceable) may be wrongly classified as priority sector, where as they may not be so, in reality. Solid evidence with regard to above is available…
b) How does a bank that claims a loan account as priority sector satisfy itself about the end user (or end use) being legitimately a priority sector target client (or end use) as per RBI norms?
The same argument is extendable to the banks, who need to ensure that their so called priority sector advances are indeed and in reality reaching people who are supposed to be target clients as per the RBI priority sector circular.
It is again surprising that despite the so called due diligence and checks by the banks, there have been cases of ghost or non-existent clients, agent led loans where end use is not traceable (could be diverted to some illegal business even), and/or multiple loans to same clients, which in fact perhaps defeats the very purpose of priority sector when the quantum of multiple loans exceeds Rs 50000 – all of these are evident from the Andhra Pradesh experience.
This is a must if priority sector advances are not to be misused and the RBI must incentivize the banks to do their routine intelligence gathering and post loan verification of end users/end use with regard to their (banks) priority sector funds. To this end, the banks must sharpen their processes with regard to KYC norms and the like…
Before I wrap up this post, I try and make several suggestions below, in terms of action that can be undertaken by RBI…in the future…Read on…
1. RBI must strengthen supervision of systemically important NBFC MFIs and especially, stronger asset side supervision must come into force to prevent (any) leakages in priority sector financing.
2. For all NBFC MFIs, the off-site monitoring of NBFC MFI trends should be undertaken by the department of non-bank supervision at RBI in a more rigorous manner so as to get early warning signals - of potential leakages – that can help prevent full blown crisis (like in AP) from occurring suddenly. The key point for the regulator is that they should not be caught unawares…as in the case of the present AP crisis
3. And the focus on the systemically important NBFC MFIs with asset size greater than Rs 100 crores should be robust (and at least from an off-site perspective) and it is pertinent to note that all the NBFC MFIs given in Annex 2 had asset size greater than Rs 100 crores by end 2009.
4. Surprise on-site inspections at select NBFC MFIs would reduce the incentives for any of the institutions to engage in priority sector excesses and that must be done as Prof Sriram has always argued. This is a must if priority sector advances are not to be misused. These inspections can also involve end users to verify whether or not the ceiling of Rs 50000/-, proposed as the upper limit for micro-credit priority sector loans, is violated by MFIs from time to time. Likewise, the implementation of the RBI and other codes of conduct, presence (if any) of multiple lending and ghost clients, use of agents, effective interest charged on the ground etc must be periodically verified from time to time
5. As with banks, for select extremely large and systemically very important NBFC MFIs with asset size greater than Rs 1000 Crores, growth and branch expansion plans must be monitored and/or supervised in some manner
6. The RBI circular on Corporate Governance is a great one but it has not been implemented till date for NBFC MFIs and there is an urgent need to bring it full implementation immediately
7. The RBI should also make banks responsible and accountable for providing verifiable details with regard to end use of priority sector loans and the actual priority sector end users. For example, the banks must also be made to certify that the MFIs that they have lent to are not misusing the priority sector funds in terms of multiple lending, lending for people/purposes other than those stipulated under priority sector and the like - the department of banking operations development (DBOD) must also set appropriate incentives for the banks to comply in this regard…
8. A final issue is that the definition of priority sector is rather weak and it does not stipulate purpose of loan. That needs to be clarified and while it is okay to lend for consumption purposes, not having a ceiling on that can prove to be disastrous as evident from the Andhra Pradesh experience of 2010. The following limits are suggested:
Overall, I feel that while regulation of NBFC MFIs may require some changes, supervision of these entities and priority sector lending requires significant strengthening…One final caveat is in order…The incentives for self regulation to work do not exist, at least in India and therefore, it would be naïve to believe that MFIs and NBFC MFIs will self-regulate. Make no mistake - any such hands off approach to regulation and supervision of MFIs will surely turn out to be a recipe for disaster…These are some initial ideas and I hope the RBI sub-Committee and RBI look into these aspects and take it forward appropriately…It is about time that the RBI formally adopts the orphaned micro-finance industry and mainstreams it as part of India’s larger financial sector…
[i] This is a description of the commercial model as I understand it…
[iii] E mail correspondence with author. Please also see http://www.microfinancefocus.com/news/2010/01/10/avoiding-a-microfinance-bubble-in-india-is-self-regulation-the-answer/
[vi] Green field client acquisition vs other strategies (including sharing of clients, takeover of SHGs/other MFI JLGs etc), market skimming (first time loans to new clients), financial deepening/multiple lending to older clients etc
[viii] CGAP, JP Morgan, occasional Paper: Microfinance Global Valuation Survey 2010, March 2010
[ix] Intellecap analysis.
[x] A listed NBFC that provides gold and vehicle loans, amongst other services.
[xi] Intellecap, Inverting the Pyramid Report (2010)
[xii] Based on provisional data made available by ARD and further information collected by the author individually from some banks.